Sustainability of Pension Schemes for Public Sector Employees in EU Member States
Report
Ministry of the Interior and Kingdom Relations
Sustainability of pension schemes / Ministry of the Interior and Kingdom Relations
Report November 2004
Contents
1. Preface 1
2. The Report of the Irish Presidency: Main Conclusions 3
3. The Aim and Scope of the Study 5
4. A Qualitative Comparison of Pension Schemes for Public Sector Employees 8
5. Quantitative Comparison of Pension Schemes 31
6. Conclusions and Recommendations 50
Appendix A 53
7. References 53
Appendix B 55
8. Assumptions 55
1
Mercer Human Resource Consulting
g:\dgmos\aos\ap&iz\internationale zaken\nl voorzitterschap\repro\engels\hrwg report public sector pensions.docSustainability of pension schemes / Ministry of the Interior and Kingdom Relations
Report November 2004
1
Preface
In Lisbon, the SPC (Social Protection Committee) was commissioned to conduct a study on the long-term development of the social security system and the sustainability of pension systems in particular. In recent years a number of studies on these issues were undertaken.[1] During the Irish Presidency a study on public sector pension systems was presented.[2] In this study, a broad range of policy issues relating to demographic trends and the sustainability of the pension systems were investigated. Chapter 2 summarises the main conclusions of the study of the Irish Presidency.
In addition to the research done during the Irish Presidency, the Dutch Presidency, through the Ministry of the Interior and Kingdom Relations (responsible for the functioning of public administration and for issues relating to civil servants), has opted for a quantitative approach to investigating the problems relating to the sustainability of pension systems operated by state employers.
Ideally the policy discussion on the future and sustainability of the pension facilities provided by state employers is conducted on the basis of a quantitative comparative study of the pension systems of all Member States. This benchmarking of pension schemes and the measures taken to reform them is aimed at facilitating the discussion between Member States on pension scheme reform. However, given the relatively short time and the difficulties involved in gathering the required data, the quantitative part of this study is limited to a comparison of pensions applicable to civil servants and other employees of governmental bodies in the United Kingdom, Germany, Italy and Sweden. The pension systems of these four countries represent a wide variety of pension systems in the EU, as will be explained in chapter 4. Chapter 4 also deals with a broader qualitative comparison of the pension systems which apply to civil servants and (other) employees of governments of those Member States (19) that responded to the questionnaire.
The quantitative analysis of the four sample pension systems provided in chapter 5 is based on the methodology and prescriptions of the International Financial Reporting Standards (IFRS), formally known as IAS, more specifically, on the IAS 19 directive on pensions and other employee benefits. This directive has been adopted by the European Council as the European Accounting Directive and is compulsory for all companies listed on a European Stock Exchange (approximately 7,000). Although the Accounting Directive is not applicable to pension provision by governments (either in the first pillar, as the social security system, or in the second pillar, as an employee benefit) it does provide an objective method for calculating the pension liabilities, which reveals the "hidden liabilities" of those pension schemes.[3]
The data for this report were gathered by means of a questionnaire sent out by the Dutch Presidency to all 25 Member States (the questionnaire is attached to this study).
19 Member States responded on the survey: Austria, Belgium, Czech Republic, Denmark, Finland, France. Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden and the United Kingdom. 6 Member States did not respond: Cyprus, Estonia, Hungary, Latvia, Lithunia and Malta. This response mirrors the overall situation of the EU Member States quite well, with regard to size, geography, moment of joining the EU and their stage of economic development.
The answers were validated and analysed by Mercer Human Resource Consulting. Mercer also performed the quantitative analyses and produced this report.
The report includes recommendations on reform measures that promote the sustainability of pension systems in the long term. The report will be presented at the DG meeting in November 2004.
2
The Report of the Irish Presidency: Main Conclusions
During the 42nd meeting of the Directors-General of the public services of the
EU Member States (Dublin, May 2004) the Irish Presidency presented a report on the "implications of demographic changes on pension systems within the public sector of
EU Member States".
Given the high degree of complexity and the variety of ways that pension systems are structured, the study was not designed to provide a comprehensive assessment of the pension systems of all Member States and the progress which has been made regarding recent reform processes. The study does, however, give insight into a broad variety of policy issues that are related to pension scheme reforms, i.e. employment and HR policies.
An important conclusion in the study is that "when reviewing the history of public pensions in many countries, it becomes clear that there have been numerous financial proposals ensuring sustainable pension systems (…); what is missing is the ability to implement them. This is intrinsic to the structure of the problem: the size of the "pension challenge" is such that proposals that look at the pension system in isolation seem unfeasible."[4]
"Even if measures seeking intergenerational justice are undertaken now" the report states, "it is likely that today's younger generations will have smaller pension benefits than their parents when they reach their parents' age."
Having said that, the report reaches to its final conclusion: "The sustainability of pension programmes is not achieved simply by fiddling with benefit levels, eligibility provisions or other financial parameters. The key to their sustainability is the future rate of economic growth which, in turn, depends on the growth of the labour force and the rate of increase in worker productivity. However, in order to create favourable conditions for generating economic growth, the length of the contribution period and the link between contributions and benefits merit active policy promotion."
Although it can be agreed upon that there are general economic and social conditions which have to be fulfilled for successful pension reform, it goes without saying that an understanding of "best practices" in pension scheme reform requires a precise insight into the quantitative effects of reform measures. Therefore the present report and the report presented by the Irish Presidency are mutually supplementary.
3
The Aim and Scope of the Study
The aim of the study is to present a comparative study of the respective pension systems applicable to public sector employees in the EU Member States with a focus on quantitative measurement and the effects of reform measures. The report should facilitate a discussion on best practices in reaching adequate and sustainable pensions for public sector employees in EU Member States.
Cost measurement
A common method of cost measurement is presented as a starting point for analysing and benchmarking the effects of pension scheme reforms. The method is based on Accounting Standards and calculates the benefit obligations (accrued obligations) and service costs (cost in current year) of pension schemes. Both the benefit obligations and the service cost are projected for a ten-year period. Subsequently the effects of reform measures and demographic changes are quantified in the cost projection.
Limitations
In this report the quantitative analysis is limited to the pension schemes of four
EU Member States, which can be considered to represent the variety of pension schemes of other Member States, as will be explained.
Because it was not possible to gather the required data within the time available during the study, we decided to measure the costs on the basis of a fictitious reference group. In this way we do not measure the pension cost of the four "sample" Member States, but the cost generating elements and the sensitivity of the pension schemes of those four Member States to demographic and economic parameters. So, using a fictitious reference group has the advantage that we measure the selected scheme types more or less on the same scale.
For a measurement of the real cost of pension schemes of public sector employees in Member States, one would have to have the reference data on public sector employees of all Member States at one's disposal. Although such a measurement would give a sound foundation for comparison between Member States – especially if the measurement is repeated periodically – this exercise lies far beyond the timeframe and budget of this study.
Definition of pension schemes
As in the survey of the Irish Presidency in this report, "pensions" means old-age pensions or retirement pensions, in contrast to survivor's pensions, disability pensions or other pension categories. In many Member States, a large part – if not all - of pension provision for public sector employees is covered by the social security system, or first pillar. Since the social security pensions are not provided exclusively to civil servants, one could argue that those pension schemes should be excluded from this study. However, pension systems in the second pillar normally assume the first pillar benefits.
Excluding the social security pensions in the comparison of – for instance – replacement rates would be like comparing apples and oranges. Therefore we compare both the first and the second pillar pensions. The third pillar (private pension provision), however, is excluded. [5]
Micro and macro analysis
Although this study deals with the public sector, primarily in its role as an employer (micro perspective), one cannot ignore the special social and economic role a government plays in society (macro perspective). In its role as an employer, the government will have to reckon with wider issues. Decisions on budgets, compensation and benefits cannot be isolated from the general budgetary constraints a government might have. Reform measures, or a lack of reform measures, in relation to public sector pensions will be assessed by the general public in the light of pension policies applicable to society at large.
In this report we will not discuss issues of general economic policy. However, we do place the pension strategies of the Member States in a broader perspective by paying attention to the government debt and the projected dependency ratio.[6] The higher the level of the projected economic dependency ratio and the current government debt, the more urgent pension scheme reform will be.
4
A Qualitative Comparison of Pension Schemes for Public Sector Employees
Aspects of pension systems in the EU
There are many respects in which European pension schemes for public sector employees differ. The details of the respective pension schemes can be found in Appendix C. We will not try to find an explanation for those differences, because this would require a historical analysis which lies beyond the scope of this report. In this chapter we focus on those aspects that have an important impact on the issues of adequacy and sustainability, as will be pointed out. In this respect we distinguish the following aspects:
§ the target level of the pension schemes;
§ incentives for increasing the number of years of service;
§ distinction between pillars: social security pensions, occupational pensions and private pensions;
§ the way the risks are shared;
§ the way the pension schemes are financed;
§ the reform measures either undertaken in recent years or planned for the near future.
At the end of this chapter we will confront the target level of pension schemes (the major indicator for the adequacy of pensions,) with the current government debt and the projected economic dependency rate. Both parameters are indicators for the sustainability of pension schemes as seen from a wider perspective, A generous pension scheme seems all the more problematic if a country has a high level of government debt and a high projected economic dependency ratio. Or, formulated differently: adequacy is a relative social concept depending on what a society can afford economically.
Finally we will give our reasons for selecting five pension schemes for the quantitative analysis in the next chapter.
Target level
The target level of a pension scheme is basically determined by the replacement rate[7] and the retirement age. The higher the benefits provided and the earlier the retirement age, the more costly a pension scheme will be, regardless of the way the scheme is financed. A difference of one year in normal retirement age –with equal benefits at the normal retirement age - means a difference in cost of approx. 8%.
There may be many reasons why the replacement rate differs between Member States. The differences in tax systems, for instance, might be a major cause of differences in the gross level of benefits. Also societies may differ in their opinion of the appropriate, socially acceptable level of old-age benefits. These different opinions may well be influenced by differences in the economic strength of Member States. For occupational or supplementary pension schemes, labour market competition will influence the quality of the scheme as well.
We have calculated the replacement rates for the average income level in a country and we have also calculated the replacement rates for 1.25 times the average income. Incomes below average were neglected to avoid complications due to differences in minimum wage levels and minimum guarantees in benefit levels. A projection was made for 40 years service with career-related and inflation-related salary increases and with indexation of accrued benefits, where appropriate according to the pension rules. [8]
Figure 1: Replacement rate for the average income level
The differences in retirement age can be caused by early retirement provisions which are sometimes alternatives for unemployment or disability benefits for older employees. As can be seen in the next table, the most common retirement age is 65. Figure 2 shows the normal retirement age and the effective retirement age (left) as well as the earliest and latest retirement age possible (right).